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Can the Yuan Challenge the Dollar?

China seems to want it, to have its currency, the yuan, replace the dollar as the world’s premier international unit, what economists call the global reserve. Though there can be no doubt that the dollar has lost the singular dominance it once enjoyed, Beijing’s effort will fail, if, that is, Beijing really wants to put the yuan in that spot. For all its problems, the dollar remains the only currency viable as a reserve. No other currency, especially China’s yuan, commands the subtle interlocking practices and positionings demanded by the role. Someday, surely, a viable challenger will arise to supplant the dollar, but that will take decades, and that next reserve may not even be one of today’s contenders.

China certainly seems intent on attacking the dollar’s position. It has pushed the yuan to stand next to the dollar in the basket of key currencies that the International Monetary Fund (IMF) uses to back its special drawing rights (SDR). Beijing has openly declared that “[i]t is a good time for this befuddled world to start considering building a de-Americanized world.” At the February 2014 meeting of the Group of 20 (G20) largest trading nations, Chinese representatives accused the United States of abusing the dollar’s reserve status, “living off printed money,” and having a “fake” economy with nothing to back its “prosperity.” Beijing has gone well beyond rhetoric, too. It has pressed Chinese firms, both state-owned and private, to use yuan instead of dollars in cross-border transactions. At last count, some 70,000 Chinese companies have complied. Beijing has signed agreements with Japan, Russia, India, Brazil, South Korea, Saudi Arabia, the United Arab Emirates, and others to do their bilateral trade in their own currencies instead of dollars. As Africa’s largest trading partner, China has also successfully promoted the use of yuan in trade there.

Beijing has enlisted the People’s Bank of China (PBOC) to secure financial arrangements that support yuan-based trading. To ensure the currency’s availability in the rest of the world, the PBOC has signed the equivalent of over $400 billion in agreements to swap currencies as per need with at least 20 other central banks. It has also established overseas facilities for clearing yuan-based transactions, making arrangements in Hong Kong, Macau, Singapore, and London and planning such arrangements in South Korea, Paris, Luxembourg, Frankfurt, Sydney, and Canada. The bank has even begun to develop a yuan-based international payments mechanism to rival the Federal Reserve’s dollar-based Fedwire system. The Chinese International Payments Systems (CIPS), as it is called, will not, however, become operational until 2016.

The efforts have paid dividends. Yuan deposits in Hong Kong have grown from 90 billion a couple of years ago to some 700 billion more recently. The annual volume of yuan-denominated bonds issued outside China, on the so-called dim sum market, has grown from next to nothing a couple of years ago to 120 billion recently. The proportion of China’s trade that is denominated in yuan has risen from a negligible amount in 2009 to over 16 percent recently and is expected to reach 30 percent by the end of this year. In this regard, the yuan has already surpassed the euro and the Japanese yen. Only 6.6 percent of euro zone trade with the rest of the world is denominated in euros, while only 1.4 percent of Japan’s is denominated in yen. In trade finance, the yuan has become the second most popular currency after the dollar. It has also jumped as a proportion of all international payment flows, though as of 2014, the most recent period for which data are available, it still ranked behind the euro, the yen, sterling, and, of course, the dollar.

Yet for all this activity and striving, the dollar remains securely dominant. It is by far the world’s most traded currency, accounting for 87 percent of the global total, up actually from the 85 percent in 2010. The euro is the next largest at a distant 33 percent, the yen at 23 percent, and sterling at 12 percent. The yuan, though up smartly from 0.9 percent in 2010, still only constitutes 2.2 percent of global currency trading. Almost 90 percent of the world’s trade contracts, over $5.0 trillion a day, are denominated in dollars, whether an American is involved or not. By comparison, the yuan constitutes an equivalent of about $100 billion a day, or only 1.5 percent of global volumes. And when the yuan is used, there is always a Chinese party involved. The IMF reports that dollars still constitutes more than 63 percent of the reserve holdings of the world’s central banks, down only slightly from 71 percent in 2000. The euro is the next largest at a distant 23 percent of the total, up only slightly from 19 percent in 2000. Sterling and the yen constitute merely 3 percent of such holdings each. In this regard, the yuan does not even rate mention.

Clearly, if Beijing wants the yuan to replace the dollar, it has a long way to go. It also carries many more handicaps than advantages in its quest. To be sure, the country’s economy is large and dynamic enough to support a global reserve currency. Even at half the size of the U.S. economy, it is significantly larger than any alternative except the euro zone. The reach of China’s trade is disproportionally greater, already rivaling that of the United States. But there are other serious questions about yuan feasibility as a global reserve. China, for one, offers neither the political stability nor the rule of law that are required of the issuer of a currency that, because of its role, people across the globe will need to hold. Nor can Chinese diplomacy or its military claim the global reach that Britain offered when the pound sterling served as the world’s reserve and the United States still does, at least for the time being. Of course China has a high military and diplomatic profile in East Asia, even a bullying one, but outside the region, its interests concern trade exclusively. It is noteworthy in this regard that despite China’s great wealth, Europe never even considered it as a resource when facing its financial crisis. When the crisis broke, the European Central Bank (ECB) immediately began to work closely with Washington, to supply needed dollar liquidity and coordinate monetary policy. It never even talked to the PBOC.

It is in the financial realm, however, that the yuan’s biggest failings lie. A global reserve currency must offer liquid trading all over the world and into every other currency. It must offer the many who must hold it an array of financial vehicles and markets broad and deep enough to trade those vehicles on a moment’s notice. Far from offering these qualities, China’s financial markets remain partly closed. Beijing still refuses to allow foreign financial institutions to operate freely in China and continues to control financial flows into and out of the country rigidly. The yuan remains only partly convertible for financial transactions. Nor does Chinese finance offer the array of financial vehicles necessary for the task or the trading volumes to provide the requisite liquidity.

Financial aggregates speak loudly to the inadequacies of Chinese finance. As of 2013, the last year for which complete data exists, China reports the equivalent of some $250 billion in financial instruments available to international traders, bankers, and investors. That figure pales next to the $9.0 trillion equivalent of sterling-based financial instruments, the $15 trillion equivalent in yen, or the $30 trillion equivalent in euros. It is less than half of one percent of the $56 trillion dollar-based instruments available. Surely, it speaks to the yuan’s inadequacies that its oldest and best-developed currency trading hub in Shanghai recently boasted that it can now trade yuan directly into ten other currencies. That is progress, but far short of what is necessary.

China may not really want global reserve status for its yuan. To be sure, Beijing wants the prestige of an internationalized currency, but it is also well aware that reserve status carries disadvantages. China’s export strategy, after all, depends in large part on a cheap yuan and Beijing knows that if the yuan were to become the global reserve, so many foreigners would need to hold it that its foreign exchange value would likely rise steeply enough to defeat this strategy. To be sure, Beijing has embarked on efforts to reorient China’s economy away from exports and toward domestic sources of growth, particularly consumption. But it knows that such fundamental reorientations take time. Consumption, after all, accounts for only 30 percent of the Chinese economy, a long way from the United States, for instance, where it amounts to some 70 percent of the economy. Beijing cannot miss the fact that exports, directly or indirectly, account for over 330 million Chinese jobs, about 30 percent of the country’s total employment and a still larger share of the new jobs created each year. It knows that until this long, arduous economic transition is complete, it must protect these jobs and the growth that exports and a cheap yuan continue to bring.

Despite all these relative dollar advantages and all the disadvantages for the yuan, there is still every reason to expect that in the fullness of time some other currency will seriously challenge the dollar’s global reserve status. In that distant future, perhaps when China has re-oriented its economy and has developed and opened its financial markets, when it has assumed a truly global diplomatic and military presence and learned to live under the rule of law, it may be the yuan. It may be the euro, when the zone has finally remedied its financial failings and overcome the other impediments standing in the way of the euro’s rise. Or it may be a currency not even considered today. Whichever currency rises to the challenge, it is clearly a long way off. Even then, if the last change in global reserve is any indication, when the dollar took over from sterling, the ultimate transition will take still longer, during which time the dollar will likely share reserve status with its ultimate replacement.